Shelagh heffernan modern banking phần 9 pps

On 17 October 1994, GE announced GE Capital was to sell Kidder Peabody to PaineWebber, another investment bank.. From Sakura to Sumitomo Mitsui FinancialGroup21 In 1991–2 Sakura Bank, th

as American Express; (c) banks in relation to their customers; (d) bank managementand employees.

5 Using the case, explain why reputation is important to the success of an ment bank

invest-6 Use the case to explain how volatile interest rates can affect the banks’ trading income.What action did the firm undertake to minimise the chance of a similar event occurring

in the future?

7 Goldman Sachs took a relatively long period of time to seek a public listing Based

on the GS experience, identify the conditions needed for a successful IPO (initialpublic listing)

8 What is corporate governance and how did it change over time at Goldman Sachs?How has going public affected corporate governance?

9 The current organisational structure at GS consists of three segments: investmentbanking, trading and principal investments, asset management and securities Theoperating results for GS appear in Table 10.2 Work out the percentage contribution

to pre-tax earnings for each of the three segments over 2000, 2001 and 2002 Whichsegments have increased their pre-tax earnings since 2000; which have decreased? Why?

10 (a) In 2002/3, Goldman Sachs was one of 10 investment banks to pay a total $110million in fines and related payments to US regulatory authorities Why? Whatimplications, if any, does this incident have for the future of Goldman Sachs?

(b) How will the Sarbanes–Oxley Act (July 2002) affect Goldman Sachs?19

11 Choose two other banks* which you consider to be major rivals to Goldman Sachs

Using their respective annual reports and sources such as Bankscope and The Banker,

prepare a table comparing Goldman Sachs with the other firms for the most recentthree years Rank Goldman Sachs in terms of: total assets, net interest margin,return on average assets, return on average equity, and the ratio of operatingexpenses to net revenue (a measure of efficiency, sometimes called the ratio ofcost to income)

(a) Are these major rivals strictly comparable, and if not, why not? What problems, ifany, did you encounter with some of these banks when compiling the data?

(b) In recent annual reports (e.g 2002), the banks report VaR figures for recent years.Briefly explain the meaning of value of risk, its advantages and limitations Canthe VaR figures reported by one bank be compared with those reported by theother two banks? If not, what are the differences?

*For example: Barclays Capital, Credit Suisse/Credit Suisse First Boston, Deutsche Bank,Dresdner Kleinwort Benson Wasserstein, HSBC, JP Morgan Chase, Lehman Broth-ers, Merrill Lynch, Morgan Stanley (Dean Witter), Schroder, Salomon Smith Barney,UBS Warburg

19 See Chapter 5 For more background reading see a brief symposium paper, ‘‘Can Regulation Prevent Corporate Wrong-Doing?’’ (pp 27–42), ‘‘Rush to Legislate’’ (pp 43–47) and ‘‘Sarbanes–Oxley in Brief ’’ (pp 48–50) These

papers appear in The Financial Regulator, 7(2), September, 2002.

10.3 Kidder Peabody Group20

Relevant Parts of The Text: Chapters 1 (investment banks, financial conglomerates) 2 and 9

(synergy, strategy)

‘‘But Leo’’, said Alan Horrvich, a third-year financial analyst at General ElectricCapital Corporation (GECC) in September 1987: ‘‘I don’t know anything aboutinvestment banking If I walk in there with a lot of amateurish ideas for what heought to do with Kidder, Cathart will rip me apart OK, you’re the boss, but whyme?’’

‘‘Look Alan’’, replied Mr Leo Halaran, Senior Vice-President, Finance of GECC:

‘‘we’ve got ten thousand things going on here right now and Cathart calls up and says,very politely, that he wants somebody very bright to work with him on a strategicreview of Kidder Peabody You’re bright, you spent a semester in the specialisedfinance MBA programme at City University Business School in London, you earnedthat fancy MBA from New York University down there in Wall Street, and you areavailable right now, so you’re our man Relax, Si isn’t all that tough If you make itthrough the first few weeks without getting sent back, you’ve got a friend for life .’’,

he ended with a grin ‘‘Me.’’

Mr Silas S Cathart, 61, had retired as Chairman and CEO of Illinois Tool Works

in 1986 He had been a director of the General Electric Company for many yearsand was much admired as a first-rate, tough though diplomatic results-oriented man-ager After the resignation of Mr Ralph DeNunzio as Chairman and CEO of KidderPeabody following the management shake-up in May 1987, Mr Cathart had been asked

by Mr Jack Welch, GE’s hard-driving, young CEO, to set aside his retirement for awhile and take over as CEO of Kidder Peabody, to give it the firm leadership itneeded, particularly now Cathart had not been able to say no His first few monthswere spent trying to get a grip on the situation at Kidder, which had been trauma-tised by the insider trading problems, and by management uncertainty as to what GEand its outside CEO were going to do to Kidder next After reporting substantial earn-ings of nearly $100 million in 1986, Kidder was expected to incur a significant loss

in 1987

Technically, Cathart and Kidder reported to Mr Gary Wendt, President and ChiefOperating Officer of General Electric Financial Services (GEFC) and CEO of GECC, butAlan understood everyone believed that old Si reported only to himself and Mr Welch

Mr Cathart wasn’t going to be in the job for that long and could not care less aboutcompany politics All he had to do was return Kidder to profitability, and set it on theright strategic course – one that made sense to both the Kidder shareholders and the GEcrowd After that, he could go back to his retirement and let someone else take over

20 This case first appeared in the New York University Salomon Center Case Series on Banking and Finance (Case 26) Written by Roy Smith (1988) The case was edited and updated by Shelagh Heffernan; questions set

by Shelagh Heffernan.

Everyone Alan had talked to at GECC felt that the job would be very tough, and thatCathart might be at a big disadvantage because he did not have prior experience in thesecurities industry.

Alan’s plan was to play it dead straight with Mr Cathart, to work most of the nightgetting the basics under his belt, and to consider Kidder’s strategic position, and how toimplement any proposed changes If asked something he did not know, he would simply say

he did not know but would try to find out A chronology of significant events is summarisedbelow

10.3.1 Chronology of Significant Events, 1986 – 87

April 1986

General Electric Financial Services agreed to pay $600 million for an 80% interest in KidderPeabody and Company, leaving the remaining 20% in the hands of the firm’s management.GEFS is a wholly owned subsidiary of General Electric Company The price paid was aboutthree times the book value – each shareholder was to receive a cash payment equal to50% of the shares being sold, the remainder being paid out over three years GEFS was toreplace the shareholder capital with an initial infusion of $300 million, with more to follow.When the transaction closed in June 1986, GE and Kidder shareholders had invested moreequity in the firm than previously announced – Kidder’s total capital was boosted to $700million

Mr Robert C Wright, head of GEFS, claimed the expansion of investment bankingactivities would mean GEFS’s sophisticated financial products in leasing and lending could

be combined with corporate financing, advisory services and trading capability at Kidders.There was no plan to institute any management changes

Kidder ranked 15th among investment banks in terms of capital, and had 2000 retailbrokers in 68 offices The view was that it was too small to compete with the giants, buttoo large to be a niche player, making it an awkward size Among analysts, it was generallyaccepted that Kidder had not been purchased for its retail network, but rather, for itsinstitutional and investment banking capabilities

Kidder initiated the talks with GE It was believed the firm agreed to give up itsindependence as a means of using a more aggressive strategy to achieve a better image – therewas a general perception that it was being left behind

October 1986

Mr Ivan Boesky was arrested for insider trading He implicated Mr Martin A Siegel,

a managing director of Drexel Burnham Lambert, who had been head of KidderPeabody’s merger and acquisition department until his departure in February 1986 tojoin Drexel

December 1986

Kidder reorganised its investment banking division Eighty-five professionals were ferred to the merchant banking division, 45 of whom were placed in acquisition advisory,

trans-and another 40 in the high-yield junk bond department The group was headed by Mr PeterGoodson, a Kidder managing director, who at the time noted the move was a fundamentalchange in management structure Mr Goodson did not anticipate any long-term effectsfrom the insider trading scandal.

February 1987

The 1986 Kidder Annual Report emphasised the importance of synergies apparent in thecombination of Kidder Peabody and GEFS – it was believed the synergies far exceededthe firm’s expectations A source of new business at Kidder was existing customer rela-tionships with hundreds of middle-sized American firms at GEF Additional capital fromGEFC allowed Kidder to provide direct financing, picking up a sizeable number ofnew clients

The Kidder Annual Report also revealed Kidder’s core business had been reorganised

to reinforce competitive strengths and facilitate future growth A global capital marketsgroup was formed under Mr Max C Chapman Jr (President of Kidder, Peabody and Co.,Incorporated), to direct the investment banking, merchant banking, asset finance, fixedincome and financial futures operations on a world-wide basis Mr John T Roche, Presidentand Chief Operating Officer, Kidder Peabody Group Inc., established an equity group MrWilliam Ferrell headed up a municipal securities group, formed from the merger of thepublic finance and municipal securities groups The CEO, Mr Ralph DeNunzio, claimedthese changes were made to ensure the firm was in a position to compete effectively in theglobal market place

February 1987

Mr Richard B Wigton, Managing Director, was arrested in his office by federal marshalls

on charges of insider trading A former employee, Mr Timothy Tabor, was also arrested.Both arrests were the result of allegations made against them and Mr Robert Freedman ofGoldman Sachs and Company by Martin Siegel, who, next day, pleaded guilty to insidertrading and other charges brought against him Kidder’s accountants, Deloitte, Haskin andSells, qualified Kidder’s 1986 financial statements because they were unable to evaluate theimpact of insider trading charges Kidder reported earnings of $90 million (compared to $47million earned in 1985); ROE was 27%

The New York Stock Exchange fined Kidder Peabody $300 000 for alleged violations ofcapital and other rules Two senior officials, including the President, Mr Roche, were fined

$25 000 each for their role in these violations

The Wall Street Journal reported that Mr DeNunzio had instructed Martin Siegel to help

start a takeover arbitrage department in March 1984; Mr DeNunzio had indicated that therole played by Mr Siegel should not be disclosed publicly – there were inherent conflicts

in having the head of mergers and acquisitions directly involved in trading on takeoverrumours A Kidder spokesman said the report was a ‘‘misstatement’’, and denied that MrDeNunzio had ordered the formation of such a unit

May 1987

Mr Lawrence Bossidy, Vice-Chairman of GE and head of all financial services, announced

a management shake-up at Kidder Peabody: Mr DeNunzio, Mr Roche and Kidder’s GeneralCounsel, Mr Krantz, would be replaced Following the arrests, GE sent in a team to assessKidder The internal investigation revealed the need for improved procedures and controls

Mr Cathart was to take over as Kidder’s CEO GE men were also brought in to fill thepositions of chief financial and chief operating officers, and a senior vice-president’s positionfor business development The board of directors was also restructured, to ensure GE had amajority of seats on the Kidder board In the same month, charges against Messrs Wigton,Tabor and Freedman were dismissed without prejudice, though it was expected they would

be charged at some future date

June 1987

GE required Kidder to settle matters with the Federal Prosecutor and the SEC In exchangefor a $25 million payment and other concessions, including giving up the takeover arbitragebusiness, the US Attorney agreed not to indict Kidder Peabody on criminal charges related

to insider trading Civil litigation against Kidder was still possible, though it would nothave the same stigma as criminal charges and conviction GEFS also agreed to provide anadditional $100 million of subordinated debt capital to Kidder Peabody

July 1987

GE announced its first half results At the time, GE said its financial services were ahead

of a year ago because of the strong performance at GECC (GE Capital Corporation) andERC (Employers Reinsurance Corporation), which more than offset the effects of specialprovisions at Kidder Peabody for settlements reached with the government It was estimatedthat Kidder had lost about $18 million in the second quarter

September 1987

Mr DeNunzio retired from Kidder Peabody after 34 years of service For 20 of these years,

he had been Kidder’s principal executive officer The Wall Street Journal reported that

morale at Kidder Peabody was improving, with GE and Kidder officials conducting a fullstrategic review of the firm It was also announced that Kidder planned to establish a fullservice foreign exchange operation and would operate trading desks in London and theFar East

1989–94

Mr Michael Carpenter joined Kidder as ‘‘head’’ in 1989, just as the bank was reeling fromthe insider trading scandal In a deal negotiated with the SEC, Kidder was required to closedown its successful risk arbitrage department This was quite a blow to Kidder because itsother businesses were only mediocre

Kidder had an excellent reputation, but was saddled with high expenses and manyunproductive brokers Half of the firm’s retail offices produced no profit at all In

1989, a number of the productive brokers left Kidder because of dissatisfaction withthe level of bonuses These departures, together with the closure of the risk arbitragedepartment, resulted in a net $53 million loss in 1989, and a loss of $54 million

in 1990

Mr Carpenter’s arrival resulted in millions of dollars and a great deal of managementtime had been spent nursing Kidder back to health The bank was also building upits investment banking operations Profits rose in 1991; in 1992 they peaked at $258million

Most of Kidder’s profits came from its fixed income securities operations, the one areawhere it had managed to establish a lead over other investment houses Underwritingand trading mortgage backed securities (MBSs) pushed Kidder up the underwriting leaguetables During this time, the profits from mortgage backed securities were said to haveaccounted for about 70% of total profits

Unfortunately, the sharp rise in interest rates at the start of 1994 hurt the mortgagebacked business The consequences of the ‘‘go for it strategy’’ with MBSs was seen in thefirst quarter of 1994 – Kidder lost more than $25 million

The same year, Kidder took a loss of around $25 million on margin trades entered intowith Askin Capital Management, a hedge fund group which had to seek protection from itscreditors, because of trading losses

Mr Carpenter’s attempts to build Kidder’s other businesses produced mixed results Byreducing costs and firing unproductive brokers, Carpenter succeeded in turning roundthe retail brokerage business – it was the most profitable business, after the fixed incomedepartment But Carpenter’s objective of achieving synergy between GE Capital andKidder Peabody had been far from successful There was a great degree of animositybetween Mr Carpenter and Mr Gary Wendt, the CEO of GE Capital It was reportedthat when clients wanted GE Capital to put up money for a deal, they would avoidusing Kidder as their investment banker Mr Welch was reported as saying, ‘‘Theonly synergies that exist between Kidder and GE Capital are Capital’s AAA creditrating’’

In April 1994 it was revealed that Kidder had reported $350 million in fictitiousprofits because of an alleged phantom trading scheme Kidder blamed Mr Joseph Jett,who had been accused of creating the fictitious profits between November 1991 andMarch 1994 Kidder had to take a $210 million charge against its first quarter earn-ings in 1994 There was also the question of how a person with so little experiencecould have been appointed to a position bearing so much responsibility This fiascowas reminiscent of a deal that went sour for Kidder in autumn 1993, which costKidder $1.7 million The deal was headed by Mr Kaplan, who like Mr Jett, had insuf-ficient experience

Both the SEC and the New York Stock Exchange (NYSE) launched enquiries into theJett affair In a report prepared by Gary Lynch (who is a lawyer with the law firm that

represented Kidder in an arbitration case against Joseph Jett), it was concluded that there waslax oversight and poor judgement by Mr Jett’s superiors, including Mr Cerrullo (former fixedincome head) and Mr Mullin (former derivatives boss) The report suspiciously supportsKidder’s claim that no other person knowingly acted with Mr Jett Kidder’s top managersshould have been suspicious because Mr Jett was producing high profits in government bondtrading – never a Kidder strength Some of the blame can be attributed to the aggressivecorporate culture of Kidder At an internal Kidder conference, Jett was reported to havetold 130 of the firm’s senior executives ‘‘you make money at all costs’’.

However, from details that have been revealed in the prepared reports, it is evident thatthere were problems at Kidder long before the Jett affair, indeed, even before Jett arrived.For example, in December 1993 Kidder had the highest gearing ratio of any bank on WallStreet, at 100 to 1 Mr Jack Welch of GE attempted to restore the reputation of GE bydisciplining or dismissing those responsible Mr Michael Carpenter was pressurised intoresigning; both Mr Mullin and Mr Cerrullo were fired

On 17 October 1994, GE announced GE Capital was to sell Kidder Peabody to PaineWebber, another investment bank The sale included the parts of Kidder that PaineWebber wished to purchase GE Capital also transferred $580 million in liquid securities

to Paine Webber, part of Kidder’s inventory In return GE Capital received shares inPaine Webber worth $670 million Thus GE received a net of $90 million for a firmthat it had purchased for $600 million in 1986, though GE also obtained a 25% stake inPaine Webber

5 What in fact happened after 1987?

6 Summarise the various scandals associated with Kidder Peabody What factors made thisfirm prone to scandals?

7 In 1994, GE divested itself of Kidder Peabody The extent of the failure of this ‘‘match’’

is illustrated by the sale of Kidder to Paine Webber for a net of $90 million, compared

to the $600 million price tag for Kidder in 1986

(a) Did GE pay too much for Kidder in 1986? Why?

(b) How much is GE to blame for the subsequent problems at Kidder? Could theseproblems have been avoided?

8 Was GE wise to take a 25% stake in Paine Webber?

10.4 From Sakura to Sumitomo Mitsui Financial

Group21

In 1991–2 Sakura Bank, the product of a merger between two other banks, was Japan’s andthe world’s second largest bank in terms of assets, valued at $438 billion It was also one ofthe largest measured by capitalisation of common stock ($41.4 billion) Roughly a decadelater, it merged again to form Sumitomo Matsui Financial Group (SMFG), and while thenew bank remains in the top 10 by tier 1 capital, it has dropped out of the top 25 in terms

of market capitalisation

Sakura Bank was formed through the merger of the Mitsui Bank, a distinguished Tokyobank which dated back to 1683, with the Taiyo Kobe Bank, a regional, largely retail bankcovering the region of Kansai, including Osaka, Kobe and Kyoto The Taiyo Kobe Bankwas itself the result of an earlier merger between the Taiyo Bank and the Bank of Kobe.The merger took place in April 1990 – the new bank was to be called the Mitsui TaiyoKobe Bank until the banks were properly integrated At that time, it would be renamed theSakura Bank, after ‘‘cherry blossom’’, a symbol of unity and grace in the Japanese culture

In April 1992, the merged bank became the Sakura Bank

Japan’s Ministry of Finance (MoF) is thought to have strongly encouraged the mergerbecause, at the time, bank mergers in Japan were rare, and usually occurred between ahealthy institution and an unhealthy one These two banks were both financially sound, butwhen the MOF ‘‘encouraged’’, banks obliged At the time, the MoF was a regulatory powerhouse and had been since the end of the war With its five bureaux (Banking, Securities,International Finance, Tax and Budget), it was the key financial regulator, engaged in allaspects of supervision: examination of financial firms, control of interest rates and products,supervision of deposit protection, and setting rules on the activities of financial firms.The newly merged bank had the most extensive retail branch network of any bank

in Japan, with 612 branches and 108 international offices The merger took place forseveral reasons:

ž To improve consolidation of the banking sector, so it is better able to compete in aderegulated market

ž To create a ‘‘universal’’ bank, providing high-quality management and informationsystems

ž To achieve greater economies of scale

ž To achieve a greater diversification of credit risk

ž To use the bank’s increased size and lending power to increase market share

Past experience had shown that Japanese bank mergers were rarely successful, becausestrong cultural links in each bank made it difficult to combine staff, clients and facilities.Furthermore, until the mid-1990s there was a reluctance to make anyone redundant from a

21 This case first appeared as Case 25 of the New York Salomon Center Case Series in Banking and Finance, written by Roy C Smith (1992) The case was subsequently edited and updated by Heffernan (1994) This version

is a major revision and update of the 1994 case.

Japanese firm or to change those in authority But the announcement, in April 1992, thatthe merged bank was ready to use its new name, Sakura, suggested these difficulties had beenovercome, and well inside the 3 years management originally announced it would take.

10.4.1 Background on the Japanese Banking System

The Japanese banking system is described in Chapter 5 of this book For many years it wascharacterised by functional segmentation and close regulation by the Ministry of Financeand the Bank of Japan During the 1970s Japanese banks experienced a period of steadygrowth and profitability The Japanese are known for their high propensity to save, so bankscould rely on households and corporations (earning revenues from export booms) for asteady supply of relatively cheap funds The reputation that the Ministry of Finance and

Bank of Japan had for casting a 100% safety net around the banking system meant, ceteris

paribus, the cost of capital for Japanese banks was lower than for major banks headquartered

in other industrialised countries

The global presence of Japanese banks was noticeable by the late 1970s, but in the 1980stheir international profile became even more pronounced because of the relatively lowcost of deposits, surplus corporate funds, and the increased use of global capital markets.Lending activities increasingly took on a global profile Japanese banks were sought outfor virtually every major international financing deal For example, in the RJR Nabiscotakeover involving a leveraged buyout of $25 billion, Japanese participation was considered

a crucial part of the financing The combination of rapid asset growth and an appreciatingyen meant that by 1994, six of the top 10 banks, ranked by asset size, were Japanese By thelate 1980s, Japanese banks had a reputation for being safe and relationship-oriented, butnothing special if measured by profit or innovations

The reputation for ‘‘being safe’’ was partly due to the MoF’s determination not to allowany banking failures in Japan – there had been no bank failures in the post-war period Itwas also known that Japanese banks had substantial hidden reserves Furthermore, banksheld between 1% and 5% of the common stock of many of their corporate customers; thesecorporates, in turn, owned shares in the bank The cross-shareholding positions had beenbuilt up in the early post-war period, before the Japanese stock market had commenced its30-year rise These shareholdings and urban branch real estate were recorded on the books

at historic cost, and until the 1990s, the market value was far in excess of the book value.The Japanese banks’ ratio of capital to assets in the late 1980s appeared to be lowcompared to their US or European counterparts, but such ratios ignored the market value

of their stockholdings and real estate Also, Japanese banks were less profitable than banks

in other countries for three reasons:

1 The emphasis on ‘‘relationship banking’’ obliged these banks to offer very low lendingrates to their key corporate borrowers, especially the corporates which were part of thesame keiretsu

2 Operating costs are relatively high

3 The Ministry of Finance discouraged financial innovation because of the concern that itmight upset the established financial system

Japanese banks appeared prepared to accept the relatively low profitability, in exchange forthe protective nature of the system.

As Japanese banks became more involved in global activities, either through internationallending, through the acquisition of foreign banks, or by multinational branching, they began

to learn about the financial innovations available by the early 1980s At the same time,

the MoF accepted the reality of imported deregulation, that is, the financial sector

would have to be deregulated to allow foreign financial firms to enter the Japanesemarket The pressure for this change came from the mounting trade surplus Japan hadwith other countries and a new financial services regime in Europe that would penalisecountries that did not offer EU banks ‘‘equal treatment’’ The MoF agreed to the gradualderegulation of domestic financial firms, and to lower entry barriers for foreign banks and

securities houses The MoF lifted some of the barriers separating different types of Japanese

banks and between banks and securities firms, and began to allow market access to allqualified issuers or investors The tight regulation of interest rates was relaxed Thoughthe full effects of the reforms were not expected to be felt until after 1994, Japanesebanks and securities firms realised they would have to adjust to the inevitable effects ofderegulation However, these reforms were relatively minor compared to what was coming(Big Bang in 1996) and, as can be seen in Table 5.8 (Chapter 5), the big changes inthe structure of the Japanese financial system did not occur until close to the turn ofthe century

10.4.2 Zaitech and the Bubble Economy

As was the case in the west, by the mid-1980s, large Japanese corporations realised thatissuing their own bonds could be a cheaper alternative to borrowing from Japanese banks

Also, an investment strategy known as zaitech was increasing in popularity: it was more

profitable for a Japanese corporation to invest in financial assets rather than Japanesemanufacturing businesses Early on, these firms borrowed money for simple financialspeculation, but over time the process became more sophisticated Non-financial firmswould issue securities with a low cash payout and use the money raised to invest in securitiesthat were appreciating in value, such as real estate or a portfolio of stocks, warrants

or options

The heyday of zaitech was between 1984 and 1989 – Japanese firms issued a total of about

$720 million in securities More than 80% of these were equity securities Japan’s totalnew equity financing in this period was three times that of the USA, even though the USeconomy was twice the size of Japan’s and it too was experiencing a boom Just under half ofthese securities were sold in domestic markets, mainly in the form of convertible debentures(a bond issue where the investor has the option of converting the bond into a fixednumber of common shares) and new share issues The rest were sold in the euromarkets,usually as low coupon bonds with stock purchase warrants attached (a security similar to aconvertible debenture but the conversion feature, as a warrant, can be detached and soldseparately) The implication of a convertible debenture issue is that one day, new shareswill be outstanding, thereby reducing earnings per share But shareholders did not appearconcerned, and share prices rarely declined following an issue

Japanese banks were keen supporters of zaitech financing, because:

ž They could underwrite the new corporate issues

ž They acted as guarantors of the payment of interest and principal on the bondsbeing issued

ž They could buy the warrants to replace stock in customer holdings, which allowed profitsfrom a portfolio to be freed up, to be reinvested on a more leveraged basis

ž Once the warrants were detached, the bonds could be purchased at a discount of 30%

to 40%

The bonds could then be repackaged with an interest rate swap, and converted into afloating rate asset to be funded on the London deposit market, and held as a profitableinternational asset

Zaitech became extremely popular among banks, corporations and investors alike, fordifferent reasons The late 1980s came to be known as the ‘‘bubble economy’’ in Japanbecause of the frequency with which financial market speculation, usually financed bymargin loans, occurred The prices of all financial assets, especially real estate and stocks,rose at rapid rates, encouraging yet more speculative behaviour

As a result of zaitech and financial surpluses, Japanese companies were no longerdependent on extensive amounts of borrowing Bank borrowing was not attractive if firmscould issue bonds, which would be redeemed by conversion into common stock in the future.The ratios of long-term debt to equity (book value) began to decline for companies listed

on the Tokyo Stock Exchange, from more than 50% in 1980 to about 39.6% at the end

of 1990 By 1990, only 42% of corporate debt outstanding, or 17% of total capitalisation,was provided by bank loans Bank loans that were negotiated often supported zaitechcorporations or investment in bank certificates of deposit, which, because of relationshipbanking, the borrower could maintain at virtually no cost

The fall in the leverage or gearing of Japanese firms was far more pronounced if equity

is measured using market prices By 1989, Japanese debt to equity ratios were half those oftheir US counterparts But although many companies used surplus cash flows to repay debt,others engaged in zaitech – increasing debt to invest in other securities

Thus, the real measure of leverage (gearing) was the ratio of net interest payable(interest received minus interest paid) to total operating income By this measure, Japanesemanufacturing companies, in aggregate, fell from 30% in 1980 to−5.3% in 1990 Thus,the manufacturing sector had become deleveraged or degeared: if zaitech holdings (based

on December 1989 prices) were sold, they would have no debt at all

10.4.3 Problem Loans and the Burst of the Bubble

Japanese banks had entered the global lending markets in the early 1980s and, determined

to capture market share, competed on interest rates The competition was not only withforeign banks, but other Japanese banks Japanese banks became highly exposed in foreignloans, beginning with Latin American debt – they held portfolios of Third World loanswhich they had lent at below market rates The MoF discouraged banks from writing offthis debt after the Mexican crisis of 1982 – it wanted them to learn from their mistakes and

exercise more discipline, and also, to limit tax credits taken by these write-offs If bankswere to write off loans, they had to do it off the books, by using the capital gains from thesale of securities and applying them against bad debt Effectively, the banks’ hidden assetsbecame their loan loss reserves.

The Nikkei index peaked in December 1989 having risen sixfold since 1979, and thenfell steadily to less than 15 000 in 1992, a 62% drop from its high The real estate marketfollowed, resulting in large losses for many zaitech players The value of their zaitechholdings declined, but there was no change in their loan obligations By the first half of

1991, bankruptcies in Japan had risen dramatically, with liabilities of $30 billion, six timesthat of 1989

As the problems escalated, companies were compelled to sell off relationship ings, which forced down share prices still further and led to expectations of future falls,which, in turn, caused further falls in share prices The share price of companies known to

sharehold-be deep into zaitech dropped even further For some they were well sharehold-below the exercise prices

of the outstanding warrants and convertible bonds that had been issued The expectationhad been that these bonds would be repaid through the conversion of the securities intocommon stock If the conversions did not take place when the bond matured, the companieswould have to pay off the bondholders Over $100 billion of warrants and convertiblesmaturing in 1992 and 1993 were trading below their conversion prices in late 1991.When the bubble burst, the number of problem loans to small businesses and individualcustomers increased dramatically The shinkin banks were the most highly exposed,and it was expected that few would stay independent – the MoF would force troubledbanks to merge with healthy ones The big banks were also in trouble, but the degree

of their problems was difficult to assess because banks were not required to declare aproblem loan ‘‘non-performing’’ until at least one year after interest payments had ceased.However, it was the long-term banks which were the most affected, because they hadbeen under the greatest pressure to find new business as borrowing by large corporationsbegan to fall Two key rating agencies downgraded the bond ratings of 10 major Japanesebanks in 1990, though most remained in the Aa category The rating agencies notedJapanese banks were a riskier investment with questionable profitability performance, butwere also confident the MoF would intervene to prevent bank failures or defaults onobligations

10.4.4 Application of the Basel Capital Assets Ratio

International banks headquartered in Japan were required to comply with Basel 1 Bankshad to meet these capital adequacy standards by the beginning of 1993 Subsequently, thebanks would have to comply with the market risk amendment approved in 1996, to beimplemented by 1998 (see Chapter 6)

The interpretation of what counted as tier 2 capital was partly left to the discretion ofregulators in a given country The MoF allowed Japanese banks to count 45% (the after-taxequivalent amount) of their unrealised gains as tier 2 capital, because these banks hadvirtually no loan loss reserves As share prices escalated in the 1980s, the value of the tier

2 capital increased, and many banks took advantage of the bubble economy to float new

issues of tier 1 capital But after December 1989, stock prices fell, and so did tier 2 capital,thereby reducing the banks’ risk assets ratios Japanese banks came under increasing pressure

to satisfy the minimum requirements

10.4.5 Sakura Bank in the 1990s

Sakura was one of the weakest performers of all the major Japanese city banks in 1991because of high interest rates, small net interest margins, and rising overhead costs Thebank’s stated risk asset ratios were, in March 1991, 3.67% for tier 1 and 7.35% for tiers 1and 2 The average for Japanese banks was, respectively, 4.35% and 8.35% Sakura’s generalexpenses as a percentage of ordinary revenues were, on average, higher than for other citybanks in the period 1988–90 Its net profits per employee were lower

In its 1992 Annual Report, Sakura Bank acknowledged the new pressures of the Basel

capital adequacy requirements, and noted that in the current environment it would bedifficult to rely on new equity issues to increase the numerator of the risk assets ratio.Sakura intended to raise capital through subordinated debt and other means, and to limitthe growth of assets The bank’s strategy was to focus on improving the return on assets andprofitability In anticipation of deregulating markets, Sakura wanted to increase efficiencyand risk management techniques

At this time, analysts believed the positive effects of the merger were just beginning to

be felt, with additional benefits expected to be realised over the next 3 to 5 years Thebenefits would be created through integration of merging branch networks and computersystems, and a reduction in personnel Though operating profits were recovering, theyremained depressed

Unfortunately, this was not to be, and like all money centre banks, Sakura faced problemswith mounting bad debt throughout the 1990s With the announcement of Big Bang in

1996 (see Chapter 5), it was clear all banks would have to adjust to a new regulatory regimeand could no longer rely on ‘‘regulatory guidance’’, whereby the banks effectively did whatwas asked of them by the MoF in return for an implicit safety net and protection in theform of a segmented market that stifled competition Recall that Sakura itself was createdfrom the merger of two banks, after pressure from the MoF As has been noted, the MoF,fearing corporate bankruptcies, discouraged Japanese banks from declaring bad loans (andmaking the necessary provisioning) in the early years after the collapse of the stock market

in 1989 Failure to write off bad debt in the early 1990s contributed to an ever-growing debtmountain throughout the decade

Since its creation in 1991, Sakura Bank has been largely focused on retail banking,with the largest number of branches among the commercial banks, and an extensiveATM network For example, it frequently topped the mortgage league tables, thoughwith a slump in property prices, a large portfolio of housing related assets is less thanideal The bank has comparatively small operations in the fields of asset management andinvestment banking

Sakura’s retail operations compete head on with the Japanese Post Office (JPO), whichhas been subsidised for years The JPO is the traditional means by which the governmentraises cheap funds to finance public institutions Until 1994, deposit rates were regulated

and higher than the rates banks could offer In 1994 they were deregulated, and in 1995, theMoF lifted restrictions on the types of savings deposits private banks could offer But sincethe Post Office is not constrained to maximise profits, it has continued to attract deposits by

offering higher rates than banks For example, its main product is the teigaku-chokin, a fixed

amount savings deposit Once the designated amount has been on deposit for 6 months, itmay be withdrawn without notice However, it can be held on deposit for up to 10 years,

at the interest rate paid on the original deposit, compounded semi-annually.22 Thus, forexample, if a deposit is made during a period of high interest rates, that rate can apply for

up to 10 years In 1996, five of the major banks (including Sakura) offered a similar type ofsavings deposit However, these banks had to respond to changes in market interest rates,and could never guarantee a fixed rate over 10 years Also, the JPO enjoys a number ofimplicit subsidies:

ž Unlike banks, the JPO does not have to obtain MoF approval to open new branches TheJPO has a branch network of 24 000; letter couriers are used to facilitate cash depositsand withdrawals in one day, through the two deliveries By contrast, Sakura Bank hadjust under 600 branches in the early 1990s, but cost considerations led to closures, so bythe time it merged with Sumitomo, the number had fallen to 462

ž The JPO is exempt from a number of taxes, including corporate income tax andstamp duty

ž It does not have to pay deposit insurance premia, nor is it subject to reserve requirements

ž JPO deposit rates are set by the Ministry of Posts and Telecommunications, rather thanthe BJ/MoF

One estimate put the state subsidy to the postal system at ¥730 billion per year, equivalent

to 0.36% on postal savings deposits.23 The result is a disproportionately high percentage(35%) of total savings and deposits being held at the Japanese Post Office, earning relativelylow rates of return In Japan, 17.8% of personal financial assets are held as JPO savingsdeposits compared to 2.9% in the UK and 1.8% in Germany.24

In September 1998, Sakura issued preference shares worth ¥300 billion ($43.7 billion)

to members of the Mitsui keiretsu and Toyota Motor Corporation The market respondedpositively, and Sakura’s share price rose, but even so, the value of the bank is 50% lowerthan what it had been 9 months earlier, and 10% below the value it was at the time it wascreated Put another way, Sakura was one of the largest banks in the world (measured byassets), but of little significance in terms of market capitalisation

In March 1999, Sakura was one of several banks to take advantage of a banking packagewhich had been approved by the Japanese Diet in October 1998 Worth ¥43 trillion ($360bn), it was to be used to revitalise the banking sector through a programme of recapitalisationand restructuring Part of the package consisted of capital injections and Sakura acceptedone worth ¥7.45 trillion – the government bought preference shares, which would convert

to ordinary banking stock between 3.5 months and 5 years

22See Ito et al (1998), p 73.

23Source: Ministry of International Trade and Industry, as quoted in Ito et al (1998), p 73.

24See Ito et al (1998), p 71.

Sakura’s attempts to raise capital through share issues reflected the pressure the bank wasunder to boost its capital to meet the Basel 1 risk assets ratio minimum of 8% Increasingprovisions for non-performing loans and a slump in equity prices (cross-shareholdings werefalling in value) had depleted the bank of capital, and reserves.25At the same time, Sakura,like most banks, is reluctant to offer new loans, making it difficult for the manufacturingand retail sectors to recover from prolonged recession Mr Akishige Okada (President)told a press conference the fresh capital was to be used for more aggressive action againstnon-performing loans, and to boost the capital adequacy ratio to 10%.

Though known for its retail banking presence, Sakura is also the key bank in the Mitsuikeiretsu, and was always obliged to grant loans to its keiretsu members at favourablerates As a consequence of this ‘‘relationship banking’’, Sakura is heavily exposed in prop-erty and related loans For example, in December 2000, Mitsui Construction requesteddebt forgiveness on ¥163 billion As the lead creditor, Sakura had to write off a sub-stantial proportion of this debt Though its global exposure is less than other moneycentre banks, it was enough to give rating agencies cause for concern By late 1998,Sakura was carrying ¥1.47 trillion ($18 billion) in problem loans A total of $11.8billion had been loaned to Asian firms, with its biggest exposures in Hong Kong,Thailand, Singapore, China and Indonesia At the time, most of these economies hadbeen severely affected by the rapid downturn associated with the Asian crisis Sakuraconsidered about 41% of these to be low risk because the loans were to Japanese affil-iated companies, with parent company guarantees Also, the bank said provisions forloan losses in Asia had been included in the ¥1.7 trillion of loan provisions made inMarch, 1998

Though Sakura’s performance was dismal throughout the 1990s, it was not all doomand gloom In September 2000, the regulatory authorities approved a plan to create

an internet bank, Japan Net Bank (JNB), by a consortium led by Sakura Sakura was

to own 50% of the new bank, and several commercial concerns put up the rest ofthe capital, including an insurance firm, Tokyo Electric Power and Fujitsu Ltd JNBoffers the standard retail banking services Deposits and withdrawals of cash are throughSakura’s ATMs, which exceed 100 000 All other transactions are conducted using theinternet For example, if a loan is approved, the borrower can withdraw the cash fromthe ATM As was noted in Chapter 2, JNB is one of two relatively successful inter-net banks in Japan Mutual funds and insurance are some of the non-bank financialservices on offer to JNB customers, reflecting the new financial structure emerging

in Japan as a consequence of Big Bang It is an example of a financial institutioncrossing the old boundaries associated with the segmented markets pre-Big Bang (seeTable 5.8)

In addition, in June 2000, it took a controlling stake in Minato Bank, a regional banklocated in Western Japan Shares were purchased from Shinsei Bank (formerly the Long

Term Credit Bank of Japan) and other institutions, making Minato Bank a (de facto)

25 In 1998, shares in other companies held by the banks were still valued at historic cost However, the banks were aware that because of the regulatory reforms, they would have to deduct equity losses from capital from 2001 and mark to market by 2002.

subsidiary of Sakura It strengthens Sakura’s presence in its home area, the Osako–Koberegion of Japan.

However, given Sakura’s profile at the onset of the new millennium, it was clear a newalliance was needed to boost its capital strength, and to avoid being left behind in thetrend towards forming mega banks Sakura was aware it might be hit by a withdrawal

of deposits from the bank, because, at the time, it was thought that the 100% depositprotection on retail deposits would be phased out by 2001.26 Sakura had hoped tointerest Deutsche Bank, but after careful scrutiny of Sakura’s strengths and weaknesses,the German bank declined to make an offer Sanwa Bank and Nomura were named aspossible suitors, until Sanwa revealed it was to merge with the Asahi-Tokai group InOctober 1999 came the surprise announcement that Sakura was to merge with SumitomoBank, to take place by April 2002 Sumitomo was considered one of the relativelystrong money centre banks, though this is by comparison with quite a lack-lustre lot.Like the merger which had created Sakura in 1992, it was completed a year early, byApril 2001

Their activities complement each other Sumitomo’s strengths were in wholesale rities and asset management In 1999, Sumitomo and Daiwa Securities had agreed a jointventure, with plans to set up a ¥300 billion fund (with GE Capital) to finance corporatemergers and acquisitions in Japan Daiwa Securities received a much needed capital injec-tion, while Sumitomo could expand in investment banking Sakura was an establishedretail banking presence, including the internet bank, Japan Net Bank, both relatively cheapsources of funds

secu-Unlike the other mega mergers, the bank holding company model was not used bySumitomo and Sakura The merger was more traditional with an exchange of shares, withSumitomo absorbing Sakura The new bank was called Sumitomo Mitsui, an immediatereminder that this merger involves two financial arms of competing keiretsu – Sumitomoand Mitsui It will have a single chairman, with 30 directors By contrast Mizuho planned

to have three chief executives, two chairmen and one president, and most of thesebanks have boards in excess of 50 members The plan was to begin providing jointservices at retail outlets, through the ATMs and internet banking The Sumitomo–Daiwaalliance will be integrated with the (relatively small) securities subsidiary owned bySakura Investment banking operations (e.g M&As) were merged, along with trustbanking and insurance operations At the time the merger was announced, the planwas to shed 9000 jobs (about a third of the joint workforce) and close overlappingbranches

The merger has been described as a ‘‘defensive’’ one, for a number of reasons:

ž At the time of the merger (2002 figures), Sumitomo Mitsui was the second largest bank

in the world measured by assets, following Mizuho Financial Group and Citigroup Both

26 To stem the increasing tide of deposit withdrawals, in 1998 the government announced a temporary 100% retail deposit protection, replacing the maximum payout of ¥10 000 yen When the full guarantee on time deposits ended in April 2002, it prompted large transfers of cash from time deposits to current accounts, cash or gold To stop this from happening again, current accounts remained covered – until March 2003, and in 2003 the deadline was extended again.

recognised that Big Bang and other factors were changing the structure of Japanesebanking, especially among the top banks – mega banks were fast becoming the norm.The Mizuho Financial Group was formed through the merger of Fuiji, Dai-ichi Kangyo,and the Industrial Bank of Japan in September 2000 In late 1999, Sanwa, Asahi andTokai banks proposed a merger, though Asahi later withdrew Instead, the UFJ holdingcompany was established in April 2001 with Sanwa Bank, Tokai Bank and Toya TrustBank At the same time, another holding company, the Mitsubishi Tokyo FinancialGroup, was created when the Bank of Tokyo Mitsubishi and Mitsubishi Trust & Bankingmerged.27

ž Japan’s regulatory authorities had nationalised a bankrupt Long Term Credit Bank ofJapan It was sold to a US investment group, Ripplewood Holdings, operating underthe new name, Shinsei Bank However, the sale has proved controversial Ripplewoodsecured a government guarantee that if existing loans fell by more than 20% belowtheir value at the time of the sale, the Deposit Insurance Corporation would buythem at the original price, thereby covering any losses, a luxury other banks donot enjoy

ž The Ripplewood deal signalled the government’s willingness to allow foreign ership of Japanese banks, bringing with them knowledge of innovative techniques(e.g expertise in the derivatives markets) lacking among Japan’s banks and increasingcompetition

own-ž The approach of 2001, when 100% protection on bank deposits was supposed to end.Sumitomo Matsui Financial Group (SMFG) faces considerable obstacles to success atthe time of writing this case The financial centres of two rival keiretsu have merged,which could upset relationships in them In the end, however, a much stronger (per-haps too strong) single keiretsu could emerge Japanese mergers, including the one thatcreated Sakura, have a poor history of overcoming cultural differences, and getting rid

of employees Both banks have serious problems with non-performing loans that havenot gone away There is also the challenge of integrating and upgrading their com-puter systems

In 2003, it was announced that Goldman Sachs would take the equivalent of a 7% stake

in SMFG, investing ¥150 billion ($1.3 billion) in return for convertible preferred shares,carrying a 4.5% cash dividend after tax A capital injection for SMFG, it gives Goldman’saccess to SMFG’s very large portfolio of distressed assets

SMFG also attempted a bid for Aozora Bank, formerly Nippon Credit Bank, untilSoftbank decided to sell its holdings in early 2003 An American private equity firmCerberus, which already had a 12% stake, successfully bid for the 49% stake giving it acontrolling interest in the bank Cerberus also announced that a US businessman was to

be Chairman of Aozora Bank of Japan The approval by the Japanese authorities is furtherevidence of the regulators’ commitment to allow foreign ownership of Japanese banks.Aozora had a relatively clean balance sheet at the time of the bid, bad loans having been

27 Around the same time, three trust banks merged: Mitsubishi Trust and Banking, Nippon Trust Bank and Tokyo Trust Bank.

written off in earlier years, and big loan loss reserves are in place for the remaining riskassets In 2003, problem loans were less than 5% of total loans, about a threefold reductionsince 2002, and its Basel 1 risk assets ratio is around 12% – about 2% higher than the topfour Japanese banks It also has close connections with regional banks.

The 2002 financial results of the big four banks were dismal, and came with anannouncement of a large increase in non-performing loans, equal to ¥26 800 billion,compared to ¥18 000 billion in the previous financial year As a result, all the big fourreported pre-tax losses At the time, they were confident they would be in profit by 2003.However, in 2003, pre-tax losses for the four mega banks amounted to ¥4000 billion ($31.7

billion) Of The Banker’s top 1000 banks, three of these banks placed at the top for pre-tax

losses SMFG was in third place after Mizuho (first) and UFI (second).28 The results weredue to exceptionally high provisioning for non-performing loans, and the new mark tomarket regulations caused a 30% fall in share prices Banks had been hopeful they couldgenerate revenue through higher lending margins (the average interest rate on corporateloans fell), fee income (increased by just 1%) and trust income (fell by 7%) Cost cutting,

in the form of job cuts and branch closures, will have to continue Sumitomo Mitsui wasconsidered to be somewhat unique, because its exposure to several large (e.g construction,property) companies leaves it in a comparatively weak asset position, and could overwhelmthe effects of improved revenues and cost-cutting The table below suggests SMGF hassome way to go on cutting costs At the time of the merger it was announced that 9000employees (one-third of its workforce) would be cut from the payroll

Branches No of employees

Source: The Banker, July issues, 1999, 2003.

SMFG, along with the other mega banks, are predicting profits for 2004 Many analyststhink the banks will be plagued by ‘‘massive’’ non-performing loans for at least anothertwo years

Questions

1 In the context of this case, explain the meaning of: (a) imported deregulation; (b) zaitech;(c) the EU’s application of ‘‘equal treatment’’ and its implications for Japanese banks;(d) ‘‘relationship banking’’ in Japan; (e) universal banking in Japan

28 They were in prestigious company: Credit Suisse Group, West LB, Abbey National and Dresdner were also in

the bottom 10 banks measured by pre-tax losses Source: The Banker (2003), p 180.

2 (a) Why has the cost of raising capital on global markets traditionally been lower forJapanese banks than for banks headquartered in western countries?

(b) Is this still the case? Give reasons for your answer

3 Using the case and the description of the Japanese banking structure found in Chapter 5,answer the following:

(a) Why would the merger of a regional bank and a city bank achieve a greaterdiversification of credit risk?

(b) Did functional segmentation encourage zaitech?

(c) Why were the long-term credit banks more heavily exposed in zaitech operationsthan other types of banks in Japan?

(d) Why is the Japanese Post Office one of Sakura/SMFG’s main competitors? Can

it build a profitable retail banking business in the presence of the JapanesePost Office?

(e) Is the ‘‘bubble economy’’ described in this case the same as Minsky’s financialfragility, defined in Chapter 4?

4 (a) What role did the MoF play in shaping the competitive capabilities of Japanesebanks?

(b) How will Big Bang and the Financial Services Agency (FSA) affect the futurestructure of Japanese banking?

5 The main Japanese banks appear, in recent years, to be setting aside large provisionsfor their non-performing loans, even though this eats into their profits Is this thecorrect strategy?

6 Achieving economies of scale and/or scope is normally cited as one of the key reasonswhy banks and other firms enter into a merger

(a) To what extent does this argument apply in the Sakura/Sumitomo merger?

(b) What strengths/weaknesses do the two banks bring with them into the merger?

(c) What are implications of this merger for the keiretsu system in Japan?

7 Using the July issues of The Banker, complete a spreadsheet on the performance of Sakura,

Sumitomo, 1992 to the most recent year possible and Sumitomo Matsui Financial Group(SMFG), 2002 to the most recent year possible For each year, report: tier 1 capital,assets, the ratio of capital to assets, pre-tax profits, the ratio of profit to capital, return on

assets, the Basel 1 risk assets ratio (The Banker calls it the ‘‘BIS ratio’’), the ratio of cost to

income, and non-performing loans as a percentage of total loans If some of the measuresare not available (na), report them on the spreadsheet as such This exercise should:(a) Explain the meaning and comment on the usefulness of each of these perfor-mance measures

(b) Compare the performance of Sakura, Sumitomo and SMFG before and afterthe merger

(c) Obtain the same financial ratios, etc for 2002 and 2003 for at least two otherJapanese banks in the top 5 (measured by tier 1 capital), two of the top 4 US banks,and two of the top 4 UK banks Comment on the performance of SMFG compared

to these other banks

(d) Discuss the future prospects for SMFG Will the merger succeed in creating aprofitable bank, able to compete on global markets?

10.5 Bancomer: A Study of an Emerging Market

Bank29

Relevant parts of text:Chapter 6 (currency, market, sovereign and political risk)

On 1 September 1982, following the moratorium on the repayment of foreign debt, a balance

of payments crisis, the imposition of exchange controls and a substantial devaluation ofthe peso, President Jos´e Lopez Portillo nationalised Mexico’s six commercial banks Overthe next 9 years, the government channelled savings from these depository institutions tofinance the national fiscal deficit The management teams of banks remained under statecontrol and given very little discretion over investment and personnel decisions There waslittle scope for strategic planning Instead, management’s focus was on making financialresources available to the government through deposit-gathering, in return for the right tolevy fees and other charges on the bank’s depositors Most of their assets were governmentbonds Mexican banks had ceased to be the primary provider of market-oriented financialservices to the Mexican public While under state ownership and control, the Mexicanbanks were well capitalised and noted for their overall stability, sustained growth andprofitability

By the beginning of the 1990s, the Mexican economy had largely recovered from thedark days of ‘‘default’’, when the country announced it could no longer service its sovereignexternal debt The Baker and Brady plans, together with IMF restructuring, had resulted inmore realistic external debt repayments, via, for example, Brady bonds (see Chapter 6), aneconomy more open to foreign competition, privatisation and fiscal reform The inflationrate fell from 30% in 1990 to 7% in 1993–4, with a reasonable annual GDP growth rate of3–4% Exchange rate policy was moving in the direction of a more liberal managed floatingregime, beginning with a fixed peg in 1988 to a crawling peg, and in 1991, a crawlingtrading band.30 Net capital inflows in the early 1990s financed a current account deficit.President Carlos Salinas, elected in 1988 for a fixed 6-year term, took much of the creditfor the economic transformation

Given other sectors had undergone extensive economic reform, it seemed gruous to have a state run banking system The President was determined to intro-duce a range of financial reforms aimed at the development of a liberalised, market-oriented financial sector In mid-1990, the Mexican Constitution was amended topermit individuals and companies to own controlling interests in commercial banks

incon-A privatisation committee was created to oversee the sale of Mexico’s banks to vate investors

pri-The Mexican Banking Law was enacted to regulate the ownership and operation ofcommercial banks Under the Financial Groups Law (1990), the universal banking modelwas adopted A range of diverse financial activities (including commercial and investment

29 This case first appeared in the New York University Salomon Center Case Series in Banking and Finance (Case

No 18) Written by Roy Smith and Ingo Walter (1992) It has been edited and substantially revised by Shelagh Heffernan Questions by Shelagh Heffernan.

30 The peso could fluctuate within a band Peso appreciation was fixed, but peso depreciation could move within a band linked to the inflation rate Source: Beim and Calomiris (2001), p306.

banking, stockbroking and insurance) would be conducted under a financial servicesholding company The plan was to use universal banking to make the Mexican bankingsystem more efficient and competitive Financial institutions could achieve economies

of scale and scope/exploit synergies, enter new markets and explore new growth andcross-marketing opportunities The reforms would also help prepare the financial sector forexpected increased competition after the North American Free Trade Agreement (1993)was reached between Mexico, Canada and the United States In 1994, the authoritiesgranted permission for the entry and establishment of 52 foreign banks, brokerage housesand other financial institutions The foreign banks provided services for blue chips andlarge businesses Mexican banks such as Bancomer would have to fight hard to retain some

of this business

10.5.1 Overview of Bancomer

Throughout its 60-year history, Bancomer’s owners and management pursued a strategywhich focused on growth in the retail and middle market sectors, with a strong marketingorientation, reflecting a willingness to respond to customer needs It operated a decentralisedmanagement structure prior to nationalisation, which, it argued, made the bank highlyresponsive to community needs Under nationalisation, decision-making became centralisedand bureaucratic, in line with the objective of gathering deposits for investment in Mexicangovernment securities

With the announcement of pending privatisation, Bancomer reasserted these gic objectives:

strate-ž Maintenance of a leading market position in retail banking and the middle market

ž Introduction of new financial products, and distribution of these products through anextensive branch network

ž Spreading financial risk through size, industry and geographic diversification of Bancomercustomers and services

ž A willingness to hire qualified managers and consultants

ž Reinvesting in Bancomer’s businesses, especially technology, branch expansion andpersonnel training

ž Maintaining conservative credit standards and diversifying risks, to ensure no single loancould have a significant effect on earnings

ž Maintenance of a strong capital base

At the end of 1991, Bancomer’s net worth was projected to be about $2 billion It waswell capitalised, and in a good position to take advantage of emerging opportunities inthe Mexican market Though the Mexican government might have been expected to be

an aggressive seller, inviting as many potential bidders as it could, political supporters

of President Salinas and the PRI (Institutional Revolutionary Party) were given specialconsideration when the banks were privatised

By the time the privatisation of the banking sector had commenced, the basic bankingskills of most banking staff were, at best, rusty, especially in the area of credit and risk

assessment, since for many years banks had been the conduit for savings to finance thegovernment’s fiscal deficit Even the key regulator, the Banco de Mexico, lacked therequisite skills and prudential rules to control bank risk taking.

Nonetheless, Bancomer undertook to improve its asset quality between 1989 and 1991

It absorbed a series of non-recurring charges and created reserves for loan losses whichsubsequently exceeded all the required regulatory levels Bancomer’s profitability during1989–90 reflected these charges and reserves, as well as the costs of refocusing the businessand the impact of recent declines in the Mexican rate of inflation As shown in Table 10.3,

in 1989–90, real profits fell by 22% but grew by nearly 66% between 1990 and 1991 Incommon with other Mexican banks, Bancomer had a growing asset base, reflecting, amongother things, impressive growth in the Mexican economy, strong demand for credit in pesosand dollars, and Bancomer’s increased market share in lending As of 30 June 1991, assetstotalled $24 billion

Higher-quality credits made up 95% of Bancomer’s portfolio as of 30 June 1991 due, lower-quality credits made up 1.78% of the portfolio, compared to 2.79% the yearbefore Reserve coverage for lower-quality credits improved during the year A credit reviewconducted by independent auditors concluded that Bancomer’s portfolio was appropriatelyclassified Bancomer was also well capitalised In June 1991, the bank’s ratio of capital toweighted risk assets was 7.4%, exceeding the 6% minimum requirement for 1991 and the7% minimum set for 1992 As can be seen from Table 10.1, the Basel ratio rose steadilythroughout the 1990s

Past-In 1991, Bancomer’s net income was forecast to grow to about $400 million, anincrease of over 50% in real terms compared to 1990 Its return on average assets was2.21%, up from 1.84% in 1990; return on average equity was 24% The net interestmargin increased from 7.22% in 1990 to 7.4% in 1991, reflecting a shift from lower-yielding government securities to higher-yielding private sector loans, together withlower-cost peso denominated deposits which made up a large portion of Bancomer’sfunding base

When privatised in October 1991, Bancomer had about 760 branches and held 26% ofMexican deposits.31It was the second largest bank after Banamex when measured by tier 1capital or assets The government sold 51% (with an option to buy another 25%) to Valres

de Monterrey S.A (Vamsa), a publicly traded financial services holding company involved

in financial leasing, factoring, warehouse bonding and broking, and one of the largest lifeinsurance firms in Mexico It was wholly owned by a very large Mexican conglomerate,Grupo Visa Visa had a variety of holdings including a beverages company PROA, aholding company, was controlled by the Garza Laguera family, which owned 86% of Visa.Another 11% of Visa shares were held by allied investors, and the remaining 3% bythe Mexican public The PROA group had experience, albeit dated, in banking, havingowned Banca Serfin S.A., Mexico’s third largest bank, before it was nationalised The Visamanagement group believed ties between Vamsa and the Bancomer group could producesubstantial synergies by combining their factor leasing, insurance and brokerage activities

31‘‘Mexico Sells 51 Per Cent Stake In Bancomer For $2.5bn’’, Financial Times, 29 October 1991.

When the Vesma/Visa group took over Bancomer, it was valued at $5bn, 2.99 times thebank’s book value.

The Chairman of Bancomer’s management group (Ricardo G Touch´e) recognised theimportance of retraining and cutting costs A comprehensive programme of changes wasdrawn up after Mr Touch´e called in an international consulting group to advise andimplement new procedures As a result, by year-end 1991:

ž Staff numbers were cut at all levels For example, one individual might coordinate thebusiness of six branches rather than having six branch managers Employee costs werereduced between 24% and 30% in the branches and between 19% and 29% in regionalcentres.32

ž In 1989, Bancomer adopted a strategy of segmenting its markets within a branch: VIPbanking (high net worth), personal banking (affluent customers but not VIP), retailbanking (for 90% of the customers) and middle market corporate banking

ž Lending was concentrated among middle market firms (companies with annual salesbetween $0.7 million and $39.7 million) and retail lending, including consumer, creditcard and mortgage loans

ž An institutional banking division was created to include international banking, corporatebanking, international finance and public finance

Outside Mexico City, Bancomer had about a quarter of the deposit market and just under

a quarter of the credit market, helped by its branch network and regional boards structure.Bancomer had a network of 750 branches; approximately 115 were in Mexico City Itcontrolled 42% of the ATMs operated in Mexico

The government financial reforms implemented between 1991 and 1992 were reaching:33

far-ž Controls on deposit and loan rates were lifted

ž Directed credit (where the state directs lending to specific sectors) was abolished

ž Since the bank privatisation programme favoured certain families, there was no uniformapplication of ‘‘fit and proper’’ criteria for management

ž All deposits were backed by a 100% guarantee, including wholesale (e.g interbank) andeven foreign deposits

ž Every bank paid the same deposit insurance premium, regardless of their risk profile,though this is the norm in most countries – the USA being a notable exception

ž Banks were not required to satisfy capital ratios that reflected their risk taking

ž Non-performing loans were recorded as the amount that had not been repaid over theprevious 90 days, rather than the value of the loan itself

In addition, a number of factors encouraged greater risk taking and/or compounded theproblems of excessive credit risk:

32Source: ‘‘Bancomer Saves $100 million through Re-engineering for Quality’’, International Journal of Bank

Marketing, 14(5), 29–30.

33 These points are from Beim and Calormiris (2001), p 310.

ž As the banks moved back into lending, the supervisory authorities were facing very largeportfolios to be monitored at a time when they, like the banks, had little training orexperience in risk management.

ž There were no experienced credit rating firms that could rate individuals or firms Norwas there much credit history available, since the banks had engaged in so little lending

up to this point

During the privatisation period in 1990–91, Mexico’s business elite paid out $12.4bn forthe banks – paying an average of 3.1 times book value – in the belief that the financialsector would grow by about 8% per year, double that forecast for the economy as a whole.Just as with Bancomer, most of the state owned banks were purchased by families owninglarge industrial concerns because they had the capital to pay out the 3 to 4 times book

value for these banks Connected lending was common given the wide network of firms they

owned In some cases, these loans were used as part of the capital to purchase the banks

To the degree that they were de facto undercapitalised, it aggravated the moral hazard

problem – go for broke – especially in the period before, during and after the crisis Thisgroup of industrialists also supported President Salinas and his liberalisation programme.Lax consumer lending would help create a feel good factor, which would be good for thePRI in the upcoming August 1994 election

After the financial reforms but before currency crisis, all banks wanted to get on thecredit bandwagon, causing loan rates to drop and rapid credit expansion in the householdand business sectors Loans to the private sector grew by 327% between 1989 and 1992.34

Commercial bank loans amounted to 10.6% of GDP in 1988 but by 1993, reached34.5%.35 With virtually no economic growth, loan losses rose sharply, and provisioningincreased By 1993, there was mounting concern about the viability of the banks Return

on assets/equity remained positive but profits began to fall – Table 10.3 shows a 27% drop

in real profits A new competitive threat was the potential entry of Canadian and USbanks (or subsidiaries of foreign banks based in these countries), which would be allowed

to establish branches over 10 years, once the North American Free Trade Agreement wassigned in 1993.36

The Mexican economy had slowed considerably in 1993 An uprising in the state ofChiapas, and two high level political assassinations of members of the PRI party (one was apresidential candidate) in 1994, intensified investor concerns about the country’s politicalstability By March 1994, there was a net outflow of capital To discourage capital flight,the government replaced its cetes (the Mexican equivalent of government Treasury bills)

with tesobonos, which, like cetes, were payable in pesos but indexed to the peso–dollar

exchange rate Effectively the government had assumed the currency risk related to holdingtheir bills, and this helped to stabilise the markets until November 1994 By this time thecurrency regime had moved from a crawling peg (1989) to a crawling trading band, two

34Cost of Credit is still too high after Privatisation-Banking, The Financial Times, 10 November, 1993, p 6.

35 Source: Beim and Calormiris (2001), p 310.

36 In 1993 (pre-agreement), Scotiabank (Canada) owned 5% of Comermex-Inverlat; and two Spanish banks Banco Bilbao-Vizcaya and Banco Central Hispano had a 20% shareholding in, respectively, Mercantil-Pobursa; and Prime-Internacional.

steps in the direction of a more liberal managed float (see footnote 30) In November,capital outflows and sales of the peso began to rise, and foreign exchange reserves began

to fall at an alarming rate, from $17.2 billion in November to $6.1 billion at the end ofDecember As Box 10.1 explains, the banks’ tesobonos swaps prompted additional margincalls as the pesos came under increasing pressure and fears about the Mexican government’swillingness/ability to service the tesobonos grew The government discovered the bankswere using tesobonos swaps and other financial engineering techniques to circumventgovernment limits (see below), the banks were told to buy dollars to cover their risks Thus,the Mexican banks themselves were significant contributors to the downward pressure onthe peso

Table 10.3 Performance Indicators for Bancomer and Other Mexican Banks

Tier 1 capital ($m)

Assets ($m)

Pre-tax profits ($m)

Real profits growth (%)

ROA (%)

Cost to income ratio (%)

Basel risk assets ratio (%)

Table 10.3 (continued)

Tier 1 capital ($m)

Assets ($m)

Pre-tax profits ($m)

Real profits growth (%)

ROA (%)

Cost to income ratio (%)

Basel risk assets ratio (%)

Source: The Banker, July issues, 1991–2004.

NA: not available.

Box 10.1 Tesobonos swaps: a lesson in market/political risk exposure 1

The Mexican government raised finance through the issue of peso denominated bond/bills known as cetes In March 1994, confronted with a new outflow of capital, it began to issue tesobonos, which was debt payable in

pesos but indexed to the peso/dollar exchange rate This meant the government assumed any currency risk arising from a future decline in the value of the peso By the end of November, they accounted for over half of all government debt outstanding Most of it was short term, despite pressure from the IMF and Washington to issue longer term debt.

Since the early 1990s, banks’ foreign currency denominated liabilities had not been allowed to exceed 15% of total liabilities Sophisticated global banks came up with a solution for Mexican banks wanting

to circumvent this rule – a tesobonos swap.2 For example, a US bank swapped income from tesobonos

in exchange for interest on a loan made by it plus collateral (in the order of $200 million) – the ter to cover the Mexican bank’s obligations under the swap The Mexican bank received dollar interest

lat-on the tesoblat-onos, which was Libor plus 4% – reflecting the higher risk lat-on the tesoblat-onos The ican bank received loan repayments (based on Libor plus a premium of say, 1%) All was well while the peso was stable The Mexican bank seemed to get a very good deal: access to dollars and a nice profit – the difference between what they paid the western bank for the loan, and the receipts from the tesobonos.

Amer-So what was in it for the global bank? The tesobonos covered the holders for any currency risk, but given Mexico’s history of reneging on foreign debt agreements, there was concern that if the currency did fall, the government might have problems servicing the debt The swap was a hedge against this eventuality, which

is exactly what happened Pressure on the peso resumed in March 1994 (see text), and continued off and

on until the currency began its free fall, losing more than 50% of its value after it was floated in December

1994 The markets became increasingly concerned about whether the Mexican government would be able

to service and/or honour its debt, especially the tesobonos because the debt obligation grew as the value of the peso declined In the autumn of 1994, the yield on the tesobonos rose and their capital value collapsed Under the swap agreement, the New York bank made an additional margin call, which meant the Mexican banks had to sell pesos for dollars Added pressure came from the Mexican authorities – when they found out about the derivative deals (in September 1994) the banks were instructed to buy an estimated $2 billion

to cover their risks, putting more pressure on the peso These actions contributed to a further decline in the currency.

These swap arrangements provide another example of inappropriate risk taking, in this case, by the Mexican banks, whose employees lacked training in the basic rudiments of credit risk assessment, never mind deriva- tives The ethics of the western banks is also questionable – they did very well out of it, buying tesobonos and hedging against the market risk associated with their falling value should the Mexican government encounter debt servicing problems In fact the government never did default on tesobonos (possibly because of the prompt rescue package); market sentiment drove down their capital value Some American economists had expressed concern that the peso was overvalued as early as 1992, and if American banks reached the same conclusion, they spotted an opportunity to enjoy fat fees from advising on and arranging the swaps, and cover their market risk at the same time.

The new President took office on 1 December but failed to announce a programme ofreforms (e.g of the banking system) Nor were interest rates increased The markets quicklylost confidence and a run on the peso began There was little choice but to allow a free float,which came on 22 December – the peso went into free fall Mexico’s close relationship withCanada and the USA meant a swift rescue package was forthcoming It consisted of $18billion from the US and Canadian governments, the Bank for International Settlements

1 This account adapted from Beim and Calormiris (2001), pp 313–314 See also Garber (1998).

2 Tesobonos swaps were the principal method for getting round the foreign currency restriction Similar instruments were offered to Mexican banks: equity swaps and structured notes In an equity swap, the foreign bank buys Mexican equity and swaps the dividend payments with the Mexican bank If it was $2 billion in equity, the Mexican bank

is loaned $2 billion (secured by the stock plus collateral) and in exchange gets the dividends plus any change in currency value from the equity The Mexican bank assumes the market risk related to the price of the equity: should it collapse in value, the bank gets higher margin calls, etc.

Structured notes were also issued: the Mexican bank buys a note from the foreign bank payable in US dollars but indexed to the peso/dollar exchange rate The note pays principal interest if the peso does not devalue but very little if there is a large depreciation The foreign bank buys cetes to hedge against its risks.

and several American commercial banks A $50 billion rescue package soon followed,organised by the same parties plus the World Bank and IMF A new recovery plan wasannounced in March 1995 which included a bank bailout fund (see below), fiscal cutbacks,wage controls and higher taxes.

In 1994, the official percentage of non-performing loans stood at 7.3%, but given theway they were calculated, this figure was a gross underestimate Thus, on the eve of thepeso devaluation, the banks were already in trouble, though delinquent loans were nottheir only problem The top Mexican banks, including Bancomer, had been persuaded

by US investment banks that they could circumvent a law that prevented them fromholding more than 15% of their liabilities in foreign currencies They did so by engaging intesobonos and other swaps While the Mexican economy and government were perceived

to be stable by investors, the banks earned good returns on the swaps, and relaxed becausethey were hedged against currency risks They apparently failed to appreciate that theseinstruments exposed them to a high degree of market risk, which would create problems assoon as investors grew concerned with the Mexican government’s ability and/or willingness

to repay its debt For the detail on the losses incurred as a result of these swaps, seeBox 6.1

Within a few months of the peso being floated, it had lost half its value against thedollar The banks really began to suffer when interest rates rose by more than 25%after the peso was floated, peaking at 80% in March 1995 Interbank rates hit 114%

in the same month, reflecting the volatility and uncertainty of the markets, thoughthey fell to 90% by the end of the month The annual inflation rate was 101% Thishigh inflation, high interest (nominal and real), recessionary environment badly affectedmany businesses, especially the smaller ones, just when entry into NAFTA left themexposed to foreign competition Households and businesses found it increasingly difficult

to service their debt The banks began to feel the strain of the rising non-performingloans To make matters worse, some banks demanded repayment of credit denominated

in dollars

In January 1995, credit rating agencies downgraded the deposits and debt of Mexicanbanks, including that of Bancomer The downgrading, it was feared, would precipitate awholesale loss of confidence in Mexican banks and force them into bankruptcy In the firstthree months of 1995, average non-performing loans (NPLs) as a percentage of total loansjumped 15% – an increase of about 45% compared to the period before devaluation Thebanking sector, already fragile, immediately collapsed

The Finance Ministry and central bank announced a rescue plan for commercial banks

in March 1995 Problem loans were to be recalculated as investment units – unidades de

inversi´on (UDIs) – the debt’s principal was indexed to inflation, paying up to 12% in real

interest rates.37 It meant 14% of the banks’ total loan portfolio, all non-performing, wasremoved from their balance sheet Weaker banks were taken over, restructured, and sold

and slashed jobs again, by about 15% However, Bancomer along with Banamex weatheredthe crisis better than other banks because both benefited somewhat from a flight to relativesafety by depositors, worried their own banks could fail At Bancomer, provisioning forbad debt was increased, to cover about 62% of its non-performing assets Even thoughBancomer’s profits fell in 1994 and 1995, they recovered dramatically in 1996, only todecline again in 1997 (see Table 10.1) Bancomer’s return on assets rose from 0.34% in

1995 to 1.31% in 1996 Compare these results with Banca Serfin, the country’s thirdlargest bank by tier 1 capital In 1995, pre-tax profits stood at $35 million, and its ROAwas 0.18%, with a Basel ratio of just 5% By 1996, Serfin was reporting losses of justunder a billion, had a negative return on assets of just under 5%, and did not report aBasel ratio Serfin never did recover from its problems, and was effectively nationalised(see below)

Under the 1995 rescue scheme, Bancomer sold 15.6 billion pesos worth of NPLs to thegovernment Nonetheless, Bancomer’s NPL stood at 9.2% in April 1996 Though muchlower than the average NPL for Mexican banks, it was very high by international standards.The bank announced it had created extraordinary reserves (2.8 billion pesos) to provisionfor the full amount of its bad loans It was the first bank to do so, Bancomer slipped intolosses during the first quarter.38

As Table 10.1 shows, the cost to income ratio, a measure of efficiency, was not reporteduntil 1996 Bancomer’s rose from 1996 onwards, reaching a high of 74.4% in 1998 – a periodduring which it was trying to cut costs Between 1998 and 1999, this ratio was reduced by12%, only to rise again in 2000, the year it was taken over From 1993 onwards, the Baselrisk assets ratios for both Banamex and Bancomer were quite respectable, well above theBasel minimum of 8% and in double digits But in the takeover year, Bancomer’s dropped

by nearly 11%, to 7.8% in 2000

As part of the reform of the banking system, it was announced that the banks were

to use US Generally Accepted Accounting Principles (GAAP) from 1997 The comer announcement regarding its bad debts was in preparation for this, but it was notenough – when GAAP was applied, NPLs rose to 18% of capital and net income (1996)fell by nearly 70% Bancomer and other banks would require a great deal more capital,and looked to foreign banks to invest in them In 1996, the Bank of Montreal hadpurchased 16% of Bancomer, but the capital injection was not nearly enough to meetits needs

Ban-At the end of March 1999, Bancomer and Banamex announced they had enteredinto talks about merging, and informed the competition authorities This move reflectedthe continued weak state of the banking sector, despite attempts to revive it post-crisis The government had absorbed a total of $65 billion of bad debt from the banks’balance sheets, and many weaker banks were taken over and/or restructured From Decem-ber 1998, foreign banks had been given the legal backing to take over the top threebanks – up to that time they were limited to a maximum of 20% of the bank Mergertalks by the top two was a defensive action, based on the idea that being biggerwould in some way resolve their joint problems of insufficient capital They expected

38Crawford, L (1996), ‘‘Bancomer in the Red After Provisions’’, Financial Times, 18 April 1996.

to make a saving of $700 million through cutting back on overlap, etc This, thebanks argued, together with their large size, would give them greater access to capitalmarkets However, if these two banks were to merge, they would have a 40% share

of the deposit market, creating concerns about lack of competition and rising ciency The authority monitoring anti-competitive practices was seen as weak because

ineffi-of the degree ineffi-of monopoly power that had been allowed to prevail in other sectors ineffi-ofthe economy This raised fears about more cartel-like behaviour, pushing up what werealready unusually high spreads, which were costly for both borrowers and savers Fur-thermore, should this new large bank get into trouble, there would be serious systemicproblems, a cause for special concern in a country with a past history of financial/bankingcrises However, soon after the two banks declared their merger intentions, the head

of the Federal Competition Commission announced he would prevent any merger fromtaking place

Despite the economic recovery between 1995 and 2000, the inability of the banks

to deal with their bad debt problems together with weak bankruptcy laws and the lack

of protection of creditor rights meant virtually no new credit was extended over thisperiod, Firms had to look elsewhere: through bond issues (if large enough), or seekingforeign or domestic investors willing to inject capital or make loans However, it wasclear Mexico needed a banking system willing to lend, prompting the government to takethe initiative

In 1998, the punto final was introduced, and was to be the last of a series of loan loss

sharing agreements between the banks and government Creditors and debtors were given

a certain date to resolve their claims If they did, creditors got up to two-thirds of the debtthey were owed, and debtors were given the last opportunity to receive government support

to pay off their debts For example, there could be a write off of mortgages of up to 50%.These generous terms resulted in over a million claims being settled, mainly individualborrowers and small firms Large debts remained outstanding – most banks thinking theycould recover more than what they would get from the state

The extent of ongoing problems in Mexico’s banking sector, four years after the 1995crisis, was made apparent when, in May 1999, the Institute for Protection of Bank Savings(IPAB) was established with a remit to deal with banks with ongoing problems It quicklytook control of Mexico’s third largest bank, Serfin Bank It was estimated at the time thatthe cost of supporting the troubled banking sector had reached $100 billion The IPAB issimilar to a ‘‘bad bank’’, but has the power to take over whole banks It is estimated to haveabout $50bn of bad loans on its books, of which $12bn originate from Serfin The IPABreported that it could take up to 20 years to deal with this bad debt It also began to dismantlethe 100% deposit insurance scheme and instructed existing banks, including Bancomer,

to raise more capital In December 1999, Bancomer complied and sold off its insurancesubsidiary At the same time Bancomer announced the development of bancassurance, i.e.that insurance products would be sold through its bank branches Normally banks expand

into bankassurance after they acquire an insurance subsidiary or partner.

Despite the sale of the large insurance subsidiary and an earlier capital injection by theBank of Montreal in 1996, the bank was still under pressure to find a capital rich partner InMarch 2000, Banco Bilbao Vizcaya Argentaria (BBVA) of Spain and Bancomer agreed that

BBVA would take a controlling interest (30%) in Bancomer The $1.2 billion deal wouldcreate the largest bank in Mexico BBVA would also take responsibility for managing thebank, to be known as BBVA-Bancomer BBVA had purchased Probursa Bank in 1995 atthe height of the crisis, and it was intended to integrate the operations of BBVA-Probursainto BBVA-Bancomer.

The first hostile bid in Mexican history came in May 2000 when Banacci, the parent

of Banamex, announced its intention to purchase 65% of Bancomer, in a $2.4 billion bid.This came as a surprise, especially after the Federal Competition Commission had declared

it would block any merger of these two banks Now, in an apparent U-turn, the authorityannounced it might allow it to proceed if the banks agreed to sell off parts where they had aclear monopoly, including credit cards and private pensions Within a month, however, thecompetition authority appeared to revert to it original position, expressing concern aboutpotential problems arising from too concentrated a banking industry

Five weeks later, the Bancomer Board approved the BBVA bid, after it offered anadditional $1.4 billion in cash, bringing the total capital raised to $2.5 billion, which isexactly what Bancomer needed given its bad debt problems The bid meant BBVA wouldown 32% of the bank, which rose to 45% after buying up the Bank of Montreal’s holding

in April 2001, and again to 54% in November 2002 It intends to own up to 65% ofthe bank

This friendly takeover of Bancomer was part of a trend of consolidation and increasedforeign ownership of Mexico’s largest banks Spain’s largest bank, Santander Central His-pano (SCH), had bought 30% of Bital Bank, which boasted the largest retail branchnetwork, and in 2001 ING took a 17.5% stake in Bital In May 2000 the IPAB, hav-ing cleaned up the balance sheet of the troubled Serfin, sold it to Spain’s SCH for

$1.5bn The new bank was called Santander Mexicano By 2001, Citigroup had takencontrol of Banamex Mexico’s banking system was now owned and controlled by giantforeign players

Post-consolidation, it is hoped that two new banking laws will help ensure the stability

of the banking system In April 2000, a new bankruptcy code of practice was established,modelled after the US system of chapter 11 administration which gives the indebted firm

an opportunity to restructure its loans for a specified period of time The courts protectthe firm from creditors in this period A second law was enacted in 2000, which protectscreditors’ rights to collateral should a firm go bankrupt In a judicial system which hadalways favoured debtors (a common feature in the legal systems of many merging markets),the two new laws went some way to redress the balance

Questions

1 Use the description of Bancomer as a nationalised bank to discuss the pros and cons ofhaving a nationalised banking system Is it a sound public policy objective?

2 In the context of the case, explain the meaning of:

(a) financial leasing;

(b) brokerage services;

(c) factoring;

(d) warehouse bonding;

(e) correspondent banking

(f) market segmentation within a retail branch

3 What did the Visa group expect to gain from the purchase of Bancomer, one of thenewly privatised major banks in Mexico?

4 Mexico is an emerging market economy What factors are unique to banks in this type

of economy? Did the new owners of Bancomer (Visa) address these issues? The answershould focus on the newly privatised bank’s strategy in terms of human resources,segmenting its markets within a branch, loan policy

5 Define ‘‘connected lending’’ and discuss whether it is likely to be a problem given Visa’scomplex ownership structure

6 Why did the currency crisis of 1994–95 lead to a downgrading of Bancomer and otherbanks’ credit ratings by private rating agencies?

7 (a) The government initiated a series of financial reforms between 1991 and 1992

To what extent were these reforms a contributory factor to the subsequent ing crisis?

bank-(b) Draw a list of financial reforms which might have reduced the chances of theMexican currency crisis from turning into a banking crisis

(c) With the benefit of hindsight, how did Bancomer’s strategic initiatives contribute

to the problems the bank faced during the crisis?

8 Were New York banks hedging against market risk, political risk or both when theyengaged in tesobonos swaps?

9 Using Table 10.1:

(a) Compare the performance of Bancomer’s risk assets ratio with the Basel minimumrequirement

(b) After takeover, BBVA-Bancomer’s risk assets ratio slumped from 18.7% in 1999

to 7.83% in 2000 Review the reasons why this ratio might have dropped sodramatically in a year

(c) Based on your observations in (a) and (b), is the Basel ratio a good measure ofperformance and/or the bank’s risk profile?

10 By early in the new century, the Mexican banking system was largely owned andcontrolled by foreign banks

(a) Within 9 years of being privatised, Bancomer (and other key Mexican banks) hadbeen taken over or sold off Why? (Crisis, bad loans, not enough capital, bankinglaw changed in 1998.)

(b) Were there sound reasons for discouraging a merger between Banamex andBancomer?

(c) What are the advantages and disadvantages of foreign ownership of banks inemerging markets (see Chapters 1 and 6 for discussion)

(d) How has BBBV-Bancomer performed since it was taken over in 2000? [Use

Bankscope (if students have access to it) OR the July editions of The Banker.]

10.6 Cr ´edit Lyonnais39

Relevant Parts of the Text: Chapters 5, 6 (political risk), Chapter 8.

‘‘Seldom in the field of finance has so much been squandered so quickly by so few.’’40

On the last working day of 1992, Monsieur Jean-Yves Harberer, Chairman of Cr´editLyonnais (CL), once again reaffirmed his plan to transform CL from a staid, state-controlledFrench bank into a high-performance pan-European universal bank, a key player in bothcommercial and investment banking markets and a cornerstone of European finance bythe turn of the century January 1993 was the eve of the EU’s first attempt41to achieve asingle market in goods/services throughout Europe, including financial services MonsieurHarberer could cite an important milestone in the road to this goal, achieving a controllinginterest in Bank f¨ur Gemeinwirtschaft, giving CL a major stake in Europe’s largest andtoughest financial services market, Germany

According to Harberer, the banks likely to be the future leaders in Europe were DeutscheBank (Germany), Barclays Bank (Great Britain), Istituto Bancaira San Paolo di Torino(Italy) and Cr´edit Lyonnais of France These leading banks would come to dominate thepan-European banking markets They would possess the capital strength, the domesticmarket share and the intra-European networks to intimidate rivals and repel competitivethreats from all sources Few others, in the opinion of Harberer, had much of a chance

Harberer had chosen the grandest strategy of all It was a strategy designed to haveenormous appeal to CL’s sole stockholder, the French government, given its proclaimedvision that a few Euro-champions needed to be nurtured in each important industrythrough an aggressive ‘‘industrial policy’’ of protection, subsidisation, ministerial guidanceand selective capital infusions Each Euro-champion (as many as possible French) must becapable of conducting commercial warfare on the global battlefield In financial services,according to Harberer, CL would be France’s chosen instrument

To achieve this objective, Harberer had three goals:

ž To make CL very, very large, with 1% to 2% of all bank deposits in the 15 (25 since2004) European Community countries To achieve this goal, CL would have to capturesignificant market share in multiple areas of banking and securities activities at once.Given the competitive dynamics of the financial services sector, speed was of the essence.Acquisitions of existing businesses would be made in various countries on several fronts,simultaneously

ž CL needed to expand and operate Europe-wide This meant going up against theentrenched domestic competition in most of the national EU markets simultaneously,either via aggressive expansion, strategic alliances and networks, or local acquisitions

39 A version of the first part of this case appeared as Case 40 in the New York University Salomon Center Case Series in Banking and Finance, written by Roy C Smith and Ingo Walter (1993) The case that appears here has been extensively edited and updated by Shelagh Heffernan.

40Source: ‘‘Debit Lyonnais’s Encore’’, The Economist, 25 March 1995, p 18.

41 Now, more than a decade later, Europe continues to strive for a single financial market The latest plan is to dismantle all barriers under the Financial Services Action Plan, 2005 See Chapter 5 for more detail.

The strategy was clear, but no one tactic would be enough Opportunism and flexibilitywere essential to success.

ž Cr´edit Lyonnais had to exert significant control over its corporate banking customers,using strategies such as deep lending, ‘‘relationship’’ investment banking with key non-financial firms, and having ownership stakes in many of these same firms Only in thisway, he felt, could CL exert sufficient influence over their financial and business affairs

to direct large and profitable businesses his way Harberer called this banque industrie, a French version of the classic German Hausbank relationship Unlike British or American

banks, owning part or all of industrial or manufacturing concerns was the norm for themajor German and French universal banks

Cr´edit Lyonnais had to retain the confidence of the French government because the stateowned the bank The government was expected to inject a great deal of capital, and clearthe way to ensure CL achieved its acquisition and ownership plans It would also have

to look beyond the inevitable accidents that occur on the road to greater glory Cr´editLyonnais would have to become an indispensable instrument of French and Europeanindustrial policy The special relationship between the government and CL would have totranscend all political changes in France, even those which involved the privatisation of

CL and other state owned banks

Little did he know that his strategy for CL would culminate in the bank being nicknamed

‘‘Debit Lyonnais’’,42 the costliest single bank bailout in European history (estimates ofbetween $17 and $30 billion), and a Los Angeles Grand Jury indicting43 MonsieurHarberer, along with five other CL executives, for fraud

10.6.1 Cr ´edit Lyonnais and Le Dirigisme Fran ¸cais

Cr´edit Lyonnais first opened for business in Lyons in 1863 as a banque de d´epˆots, which

collected deposits, made loans and underwrote new issues of debt and equity for its corporateclients The bank extended its operations to London during the Franco-Prussian war and,

in the 1870s, expanded throughout France and to the major foreign business centres By

1900, it was the largest French bank, measured by assets

During the First World War, many of the personnel from the large French banks wereconscripted, and competition in French banking increased Smaller banks took advantage

of larger banks’ staffing difficulties and expanded rapidly From 1917, the Cr´edits Populaires,

a new form of banking establishment, arrived, adding to domestic competition The 1917Russian revolution led to the withdrawal of many deposits by wealthy Russian nationalswho had fled the country Though it was profitable in the 1920s, CL was not making nearlythe profits it had enjoyed before the Great War

During the Great Depression of the 1930s, CL adopted a cautious approach, closing about

100 offices in France and abroad With the onset of the Second World War, CL remainedessentially apolitical, continuing the majority of its banking activities, although some of

42‘‘Debit Lyonnais, Again’’, The Economist; 28 January 1995, p 15.

43 Under the US system, an indictment contains charges that an individual committed a crime, but all defendants are presumed innocent until proven guilty.

the foreign offices fell out of the control of Head Office during the German occupation.The restoration of peace in 1945 brought with it a number of events central to determiningCL’s future course.

1945

The French government nationalised the banques de d´epˆots, including Cr´edit Lyonnais,

Soci´et´e G´en´erale, Comptoir National d’Escomptes de Paris (CNEP) and Banque Nationale

de Commerce et d’Industrie (BNCI) In 1966, the government merged the two smallerbanks, CNEP and BNCI, into Banque Nationale de Paris (BNP)

1970

The president of CL, Fran¸cois Bloch-Lain´e, adopted a strategy of forming partnershipswith other banks in the form of a Union des Banques Arabes et Fran¸caises (UBAF) andEuropartners

1973

A law was passed allowing the distribution of shares to the employees of nationalised banksand insurance companies such as Cr´edit Lyonnais The election victory of the Gaullists,led by Val´ery Giscard d’Estaing, resulted in the appointment of Jacques Chaine to replaceFran¸cois Bloch-Lain´e as chief executive of CL

1981

The Socialists won a resounding election victory and Fran¸cois Mitterand became President

of France Jean Deflassieux, financial advisor to the Socialist party, was appointed to replaceJacques Chaine at CL

1982

The ruling Socialists nationalised all the major French banks not already owned by thestate The declared objective of the government was to influence the functioning of banks

to favour the small and middle-sized businesses, as well as to help define and implement

a new and more interventionist industrial and monetary policy For Cr´edit Lyonnais, theonly effect was the renationalisation of shares sold to employees in 1973

1986

The Gaullists took control of the French Legislative Assembly, and Jacques Chirac wasappointed as Prime Minister There was a period of ‘‘cohabitation’’ with President Mitterand.Jean Deflassieux was replaced as CL chief executive by Jean-Maxime L`evˆeque, known forhis advocacy of privatisation A privatisation law authorised the public sale of 65 largeindustrial companies, though CL was not targeted in the first round Both Groupe Financi´ere

de Paribas and the Soci`et`e G`en`erale were successfully privatised

TEAM FLY

persistent intervention by the state, commonly known as dirigisme After nationalisation

in 1945, CL had experienced a reasonable degree of independence (most of the CL boardremained intact), but the government became increasingly interventionist, defining thebank’s strategic direction and the structure of its leadership, with a view to using thenationalised banks as a key tool of industrial policy

Despite the political situation, the French financial system underwent substantial tural change and deregulation in the 1970s and 1980s It was transformed from beinghighly concentrated and compartmentalised into an open, well-developed domestic capitalmarket The deregulation was a partial response to London’s financial reforms, which theParis financial markets had to keep up with; it was also due to changing political fashion

struc-In particular, the financial reforms under the Chirac administration helped shift Frenchcorporate finance towards open capital markets and away from bank lending

The major French banks and industrial enterprises remained tied together by strong,informal relationships, a cohesion that had its roots in the Grandes ´Ecoles, attended byleading government officials and senior managers of state owned and private companies andbanks The best graduates became Inspecteurs des Finances, a special appointment for thebrightest graduates of the elite ´Ecole Nationale d’Administration This virtually ensuredinstant prestige for an individual, lifelong admiration, and responsible employment in theFrench government or in government-controlled entities

Jean Yves Harberer was a paragon of this system He graduated first in his class at the ´EcoleNationale d’Administration and joined the French Treasury as an Inspecteur G´en´eral desFinances He rose rapidly, becoming head of the French Treasury while still in his forties

In 1982 President Mitterand moved him from the Treasury to run the newly nationalisedParibas (Compagnie Financi`ere de Paris et des Pays-Bas) Harberer was widely resented atParibas, and was seen as the instrument of its nationalisation During his leadership, Paribassuffered its worst fiasco – it acquired the New York stockbroker AG Becker, which it sold

at a $70 million loss a few years later When Paribas was reprivatised in 1986, Harbererwas removed from office, but was subsequently appointed chief executive and president ofCr´edit Lyonnais in 1988